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Financial Stability in European Banking: The Role of Common Factors

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  • Clemens J.M. Kool

    (Utrecht University)

Abstract

In this paper, I investigate the development and determinants of CDS spreads for 18 major European banks between December 2001 and January 2004 using daily data. I demonstrate that two nonstationary common factors can be extracted from the data that together explain most CDS spread variation across time and across banks. The group of German banks plus a few Southern-European banks appear to systematically have high CDS spreads and to be relatively sensitive to changes in the underlying factors. The dominating first common factor impacts on all banks in a similar direction, suggesting strong market integration. However, the quantitatively less important second factor has opposite effects on credit spreads of Southern European versus Northern European banks, suggesting some remaining country-specific or region-specific credit risk. Finally, I show that the first common factor may indeed be interpreted as a measure of market conditions as it is cointegrated with the European P/E ratio and the 2-year nominal interest rate

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Paper provided by Money Macro and Finance Research Group in its series Money Macro and Finance (MMF) Research Group Conference 2006 with number 101.

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Date of creation: 02 Feb 2007
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Handle: RePEc:mmf:mmfc06:101

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Web page: http://www.essex.ac.uk/afm/mmf/index.html

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Keywords: credit default swap spreads; contagion; cointegration; factor analysis;

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